Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Avoiding the inflation volatility shipwreck
For investors trying to figure out how to navigate inflation volatility, an infamous shipwreck might hold the answers.
The question of whether inflation is transitory or structural is likely the wrong question to be asking.
UK-based investment house Ruffer believes that it’s both: that the inflation tide will come in and go back out repeatedly, bringing significant volatility along the way; that it’s near-impossible to time the tops and bottoms; and that investors are plunging headlong into the breach without rethinking their approach.
“We think that the facts have changed. The trouble is that investors appear to be confident that they can change their portfolio approach in time to avoid the troubled waters ahead,” said Ruffer investment manager Katherine Forsyth. “We think this is a mistake, and it’s much more prudent to prepare before financial conditions tighten and volatility becomes properly embedded.”
Inflationary pressures that existed even before the pandemic – and which have since accelerated – mean policy will need to be tightened “very sharply and very quickly”. One problem that will likely amplify the damage is that economies have become “hyper-financialised.”
“This is easily spotted with the amount of leveraged buyouts, huge financial engineering, and, most telling, executive pay linked to stock and stock options,” said Alex Lennard, Ruffer investment director. “The result of this is growthless asset-value maximisation, a severing of the link between shareholder value and profits. And this leads to a tendency for people to prioritise short-term profits over long-term planning.”
“This really shouldn’t surprise us; the Federal Reserve has been openly targeting financial conditions for some time, but the trouble is that most of the stimulus has gotten stuck inside finance.”
And while that stimulus has generated some real growth, that growth has also been supported by asset markets and fiscal policy. US consumer spending has enjoyed its sharpest recovery from a recession since WWII – but it’s all built on “some pretty weak foundations”.
“The worry, and the delicious irony, is that the stronger the economy is, the more vulnerable, fragile, expensive capital markets look as policymakers will have to press the brakes harder,” Lennard said. “What the economy needs, financial markets almost certainly can’t handle.”
The metaphor that Forsyth uses to describe investors caught in this paradigm is that of the SS Torrey Canyon, a historical oil supertanker that ran aground off the coast of the United Kingdom in 1967 when its captain refused to change course, despite lacking navigational charts, in order to keep his tight schedule. The wreck caused the largest environmental disaster in history at the time.
“In this case, the particular problem was plan continuation bias – the unwillingness to change course even though mounting evidence suggests you should reconsider,” Forsyth said. “We think markets are undoubtedly faced with mounting obstacles and that there’s cross-currents in the form of the virus and geopolitics and policy making. And investors are relying on the same set of maps that they have done for 40 years; investing for a world of falling inflation and falling yields.”
“If the tide has indeed turned for inflation, we worry that investors will have neither the foresight nor the tools to navigate these rough waters, and the trusty maps they’ve been relying on might be very out of date.”
Ruffer believes that asset managers are unwilling to forego upside in a world that has become “so intolerant of underperformance”, but that they’re also unlikely to be able to reactively change their portfolios to the new conditions.
“While bond markets are intolerant to rising interest rates, equity markets are perhaps even more vulnerable should rates rise,” Lennard says. “Despite this obvious risk, a lack of attractive alternatives means that investors are forced to stay at the party and will perhaps only leave when the police have called an end to proceedings.”
Ruffer has historically used standard index puts for equity protection, along with measures more focused on volatility like VIX calls. To defend against rising rates, they use “swaptions”, which provide payoffs when yields are rising.
“Hedges are going to need to be paid for. This might mean giving up upside if you want to build true anti-fragility into portfolios,” Lennard said. “Cash, might at times, be king. This is an unequivocally uncomfortable asset to be holding in an inflationary word, but it is an essential arrow to have in one’s quiver to pick up opportunities as they arise.”
